Steven Bennett is Chief Executive Officer of Charter Hall Direct, part of the Charter Hall Group (ASX:CHC), and is responsible for funds under management of over $10 billion in unlisted property funds.
GH: Which sections of commercial real estate are most resilient to rising inflation and interest rates?
SB: Any asset class that can exhibit strong income growth or pricing power is generally resilient to inflation and interest rates, regardless of whether you're talking equities or commercial property. A key advantage of Australian commercial real estate is the fixed rent increases. They may be CPI or a fixed percentage but contractually, they're locked in on an annual basis. For example, our $3.2 billion Direct Office Fund has annual average increases of 3.6% which in the context of long-term inflation targeting by the Reserve Bank of 2% to 3% is attractive. Many buildings have ‘triple net leases’ where the tenant is responsible for building outgoings (see explanation in previous interview).
GH: Do many of the leases build in CPI increases?
SB: Of the $61 billion of real estate that Charter Hall manages, about 25% is CPI-linked, 24% is triple net leases and the balance is a combination of fixed rental increases. It varies by fund. The best protection is to have pricing power in your assets. In an office building, that means prime institutional-grade assets, with good amenity, cafes and restaurants, close to public transport, strong ESG. In the industrial space, proximity to infrastructure, toll roads, motorways, ports. These features give the ability to protect the rental yields, but secondary or lower-quality assets where there's a lot more choice and people don't necessarily need to be in those assets long term are more difficult.
GH: Is there a part of the market which doesn't have this level of pricing power?
SB: In the last few years, although we're not really in this space, the large discretionary malls with tenants that are competing against online entrants have had a difficult time maintaining headline rents, and some of those asset values have come off 15 to 20%. At the other extreme, the small neighbourhood shopping centers anchored by a Coles, Woolies or Aldi are extremely resilient. They continue to increase their sales turnover and it's been a good story for investors in non-discretionary retail.
GH: Yes, we still need to buy groceries. We all know about the labour and materials shortages on the residential side, but how has it affected your business?
SB: We have a large development pipeline across the Charter Hall Group, roughly $12 billion spread $7 billion in office and $5 billion in industrial logistics. But because we're building to own the assets long term, and not necessarily for speculative development, we approach our developments differently. We've de-risked them wherever possible with pre-committed leases, we use fixed price building contracts and we only employ tier one building firms that are financially strong.
We also benefit from experienced development teams, and they’ve been on the front foot ordering components and parts. For example, at 60 King William Street, our new Adelaide office development, we ordered the plant and equipment early. At 555 Collins Street in Melbourne, we have 13 levels of glass facade in storage in Australia. It reduces the supply chain issues that are coming out of Asia and China in particular.
GH: Do you have a view on when these global supply issues might return to ‘normal’?
SB: Lots of variables there. Shipping costs are still elevated, higher building costs especially in locations outside Sydney and Melbourne. We are expecting prices to stabilise later this calendar year and through into 2023, but it’s dependent on globally moving away from Covid-zero policy settings.
GH: What are some of the global trends in commercial property that we might see more in Australia?
SB: Offshore the build-to-rent or multifamily sector is continuing to develop. Additionally there is a large and growing focus on allocations into property which are underpinned by data centers, biosciences and a renewed focus on health and education facilities.
GH: Biosciences, that's like the big facilities producing vaccines, that sort of scientific work?
SB: Yes, exactly. We've got an asset that does the Red Cross blood distribution at Alexandria in New South Wales, strategically located near the airport. They can move highly-perishable items at short notice and they have 24-hour deliveries coming and going from that centre.
GH: If you think back to pre-pandemic days, say three years ago versus now, what have been the major changes?
SB: There's more focus on tenant quality than ever before, finding tenants that are financially strong, with good balance sheets, ample free cash flow and strong demand for their products. For example, with our own PFA Fund in the office market, 60% of the rent is paid by federal and state government entities. Our two office funds are attracting equity investments because of that.
I do think some people have made strategic mistakes underestimating CBD activity. They moved their small offices to working from home a two-hour commute from the city but they are missing the eye-to-eye personal contact involved in winning business. There are great things about working in the CBD.
On the ESG side, particularly the 'E' for environmental, we receive questions from investors on whether our properties or the tenants within them are delivering positive environmental outcomes. In the office markets, there’s a major flight to quality with prime space seeing the lion's share of tenant demand, and there’s an increased obsolescence risk for inferior offices. In industrial and logistics, there is a turbocharged universe with three trends around onshore versus offshoring, just-in-case inventory versus just-in-time inventory, and the continued growth of ecommerce. In retail, people now have a greater understanding of the difference between discretionary and non-discretionary retail.
GH: So what’s happening with B-grade office buildings?
SB: Tenants want space that hits their environmental rating, and it's very difficult to deliver those standards on B- and C-grade assets. The capital cost can be prohibitive and sometimes you functionally just can't do it. And if a company wants its team back in the office, it needs a more flexible workplace, areas that encourage collaboration, where staff want to work in a pleasant space with great natural light. If you're not offering those things, why would staff want to come back into the office? So the pandemic has sped up the risk of obsolescence in the lower quality assets.
GH: Charter Hall offers both unlisted and listed funds. If an investor is looking for exposure to property, does the business make a case one way or the other?
SB: We don't believe that one form of property investment structure is inherently superior to the other. We do run three large listed property vehicles (retail ASX:CQR, social infrastructure ASX:CQE, long WALE ASX:CLW) and of course, our parent is listed (ASX:CHC). We encourage people to check what structure suits their requirements. Liquidity is a key benefit of the listed market, but if an investor wants less variability in returns and prices linked more to the underlying value of the properties, then unlisted may be the way to go. It depends on the desired investment outcome. I've got both in my own SMSF because I don’t want my entire portfolio doing the one thing, they work together.
GH: I'm the same. One aspect I like about the unlisted segment is it’s easier to set-and-forget, there’s no daily sharemarket asking me to assess the price and I expect I'll just leave money there for decades. I want some of that as a core in my portfolio.
SB: Yes, and it does stop people from exiting the market at the worst possible time. For example, we have 10 funds in the direct suite, and the returns over the two-year period from March 2020 to March 2022 - completely pandemic-impacted - show the lowest return was 12.6% per annum and the highest return was 28% per annum. All other funds fell somewhere between. But if there was daily liquidity a lot of investors would have exited at the start of the pandemic and missed those great returns. So there is a lot of value in what you just said, take a long-term approach without assessing your investments each day.
GH: While no parent can have a favourite child, do you think there's a specific fund in your suite which is looking the best at the moment?
SB: We don’t like to give investment advice, even in interviews like this, so let me describe some trends and allow people to draw their own conclusions. The biggest growth is in the Charter Hall unlisted Long WALE (Weighted Average Lease Expiry) Fund. It's diversified, pays monthly distributions at a rate of 5.4% per annum, and we pick the sectors we think will deliver the best medium- to long-term returns. The biggest flows by quantum are into the Direct Industrial Fund number four (DIF4) with industrial logistics and those three key thematics I mentioned before. And it may surprise people that we've raised over $250 million in our Direct unlisted office funds in this financial year, with many investors looking through the short-term noise around the pandemic.
GH: I know the management team would prefer to focus on the day-to-day business rather than worry about the Charter Hall share price, but it’s been amazing to watch it go from $14 in early 2020, down to about $5 in the pandemic, then soar to $22 at the end of 2021, and now back to $13. It's been a rollercoaster, despite the business consistently growing. What’s the feeling in the business? Is it frustrating that the market reacts with such extremes?
SB: We know that listed markets can be volatile and ultimately, we don't price the stock, the market does. The leadership team at Charter Hall focusses on driving the earnings. That's the one thing we can control, and we believe that over the long term, the share price will follow earnings. Over the last five years, we've delivered EPS growth of 25% per annum and we aren't caught up in the day-to-day share price. Our underlying funds continue to perform and that's why we've had such strong success in raising capital.
Graham Hand is Editor-At-Large at Firstlinks. Steve Bennett is Chief Executive Officer at Charter Hall Direct and was elected President of the Property Funds Association in April 2019. Charter Hall is a sponsor of Firstlinks. This article is for general information purposes only and does not consider the circumstances of any person, and investors should take professional investment advice before acting.
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